Chapter 4, Fundamentals of Accounting I PDF

Chapter Four Accounting for Cash LEARNING OBJECTIVES After studying this chapter, you should be able to: 1. Define Cash. 2. Distinguish items that are reported as cash. 3. Define fraud and internal control. 4. Identify the principles of internal control activities. 5. Explain the applications of in...

Chapter Four Accounting for Cash LEARNING OBJECTIVES After studying this chapter, you should be able to: 1. Define Cash. 2. Distinguish items that are reported as cash. 3. Define fraud and internal control. 4. Identify the principles of internal control activities. 5. Explain the applications of internal control principles to cash receipts and cash disbursements. 6. Describe the operation of a petty cash fund. 7. Indicate the control features of a bank account. 8. Prepare a bank reconciliation. 9. Explain the reporting of cash. 4.1. Introduction- What is Cash?  Cash is a medium of exchange that a bank will accept at face value and immediate credit to the depositors account.  An item to be reported as cash it must fulfill the following criteria’s: 1) It should be used as a medium of exchange, i.e. in settlement of transactions. 2) It should be available immediately for the payment of current obligations. 3) It should be free from any contractual restriction that limits its use in satisfying debts Items those are included as Cash  Coins and Currencies (Paper money)  Money on deposit in a bank that can be drawn with out any restriction, i.e. demand deposits  Negotiable instruments, which are documents that can be transferred from one party to another as money, like money orders, certified checks or CPO’s, checks issued by third parties and are available at cashiers, checks written to third parties but not yet issued, traveler’s checks, etc  Saving accounts  Petty cash funds  Change funds  Credit card sales draft  Cont’d  Some items, however, may initially appear or seem as Cash; but do not meet the criteria’s.  For instance, a check received from a third party, as a payment is not included as cash if the party issuing the check has not sufficient fund in its bank account.  Such checks are marked as NSF (Not Sufficient Fund) checks and are reported as receivables.  Similarly, Post dated checks, issued by third parties but that will be drawn only in the future dates, reported as receivables.  Postage Stamps are items for which cash has been paid and are expected to be used in the future. They represent office supplies (prepaid expense items).  4.2. Fraud & Internal Control Fraud Dishonest act by an employee that results in personal benefit to the employee at a cost of the employer. Three factors that contribute to fraudulent activity. Illustration 7-1 Fraud Triangle  Cont’d Internal Control Methods and measures adopted to: 1. Safeguard assets. 2. Enhance accuracy and reliability of accounting records. 3. Increase efficiency of operations. 4. Ensure compliance with laws and regulations.  Cont’d Question #1 Internal control is used in a business to enhance the accuracy and reliability of its accounting records & to: a. safeguard its assets. b. prevent fraud. c. produce correct financial statements. d. deter employee dishonesty.  Cont’d Five Primary Components: Control environment. Risk assessment. Control activities. Information and communication. Monitoring. Principles of Internal Control Activities ESTABLISHMENT OF RESPONSIBILITY  Control is most effective when only one person is responsible for a given task.  Establishing responsibility often requires limiting access only to authorized personnel, and then identifying those personnel. ANATOMY OF A FRAUD Maureen Frugali was a training supervisor for claims processing at Colossal Healthcare. As a standard part of the claims processing training program, Maureen created fictitious claims for use by trainees. These fictitious claims were then sent to the accounts payable department. After the training claims had been processed, she was to notify Accounts Payable of all fictitious claims, so that they would not be paid. However, she did not inform Accounts Payable about every fictitious claim. She created some fictitious claims for entities that she controlled (that is, she would receive the payment), and she let Accounts Payable pay her. Total take: $11 million The Missing Control Establishment of responsibility. The healthcare company did not adequately restrict the responsibility for authorizing and approving claims transactions. The training supervisor should not have been authorized to create claims in the company’s ―live‖ system.  Cont’d SEGREGATION OF DUTIES  Different individuals should be responsible for related activities.  The responsibility for record- keeping for an asset should be separate from the physical custody of that asset. ANATOMY OF A FRAUD Lawrence Fairbanks, the assistant vice-chancellor of communications at Aesop University, was allowed to make purchases of under $2,500 for his department without external approval. Unfortunately, he also sometimes bought items for himself, such as expensive antiques and other collectibles. How did he do it? He replaced the vendor invoices he received with fake vendor invoices that he created. The fake invoices had descriptions that were more consistent with the communications department’s purchases. He submitted these fake invoices to the accounting department as the basis for their journal entries and to the accounts payable department as the basis for payment. Total take: $475,000 The Missing Control Segregation of duties. The university had not properly segregated related purchasing activities. Lawrence was ordering items, receiving the items, and receiving the invoice. By receiving the invoice, he had control over the documents that were used to account for the purchase and thus was able to substitute a fake invoice. ANATOMY OF A FRAUD Angela Bauer was an accounts payable clerk for Aggasiz Construction Company. She prepared and issued checks to vendors and reconciled bank statements. She perpetrated a fraud in this way: She wrote checks for costs that the company had not actually incurred (e.g., fake taxes). A supervisor then approved and signed the checks. Before issuing the check, though, she would ―white-out‖ the payee line on the check and change it to personal accounts that she controlled. She was able to conceal the theft because she also reconciled the bank account. That is, nobody else ever saw that the checks had been altered. Total take: $570,000 The Missing Control Segregation of duties. Aggasiz Construction Company did not properly segregate record-keeping from physical custody. Angela had physical custody of the blank checks, which essentially was control of the cash. She also had record-keeping responsibility because she prepared the bank reconciliation.  Cont’d DOCUMENTATION PROCEDURES  Companies should use prenumbered documents, and all documents should be accounted for.  Employees should promptly forward source documents for accounting entries to the accounting department. ANATOMY OF A FRAUD To support their reimbursement requests for travel costs incurred, employees at Mod Fashions Corporation’s design center were required to submit receipts. The receipts could include the detailed bill provided for a meal, or the credit card receipt provided when the credit card payment is made, or a copy of the employee’s monthly credit card bill that listed the item. A number of the designers who frequently traveled together came up with a fraud scheme: They submitted claims for the same expenses. For example, if they had a meal together that cost $200, one person submitted the detailed meal bill, another submitted the credit card receipt, and a third submitted a monthly credit card bill showing the meal as a line item. Thus, all three received a $200 reimbursement. Total take: $75,000 The Missing Control Documentation procedures. Mod Fashions should require the original, detailed receipt. It should not accept photocopies, and it should not accept credit card statements. In addition, documentation procedures could be further improved by requiring the use of a corporate credit card (rather than a personal credit card) for all business expenses.  Cont’d PHYSICAL Illustration 7-2 Physical Controls CONTROLS  ANATOMY OF A FRAUD At Centerstone Health, a large insurance company, the mailroom each day received insurance applications from prospective customers. Mailroom employees scanned the applications into electronic documents before the applications were processed. Once the applications are scanned they can be accessed online by authorized employees. Insurance agents at Centerstone Health earn commissions based upon successful applications. The sales agent’s name is listed on the application. However, roughly 15% of the applications are from customers who did not work with a sales agent. Two friends—Alex, an employee in record keeping, and Parviz, a sales agent—thought up a way to perpetrate a fraud. Alex identified scanned applications that did not list a sales agent. After business hours, he entered the mailroom and found the hardcopy applications that did not show a sales agent. He wrote in Parviz’s name as the sales agent and then rescanned the application for processing. Parviz received the commission, which the friends then split. Total take: $240,000 Total take: $240,000 The Missing Control Physical controls. Centerstone Health lacked two basic physical controls that could have prevented this fraud. First, the mailroom should have been locked during nonbusiness hours, and access during business hours should have been tightly controlled. Second, the scanned applications supposedly could be accessed only by authorized employees using their passwords. However, the password for each employee was the same as the employee’s user ID. Since employee user-ID numbers were available to all other employees, all employees knew all other employees’ passwords. Unauthorized employees could access the scanned applications. Thus, Alex could enter the system using another employee’s password and access the scanned applications.  Cont’d INDEPENDENT INTERNAL VERIFICATION  Records periodically verified by an employee who is independent.  Discrepancies reported to management. Illustration 7-3 Comparison of segregation of duties principle with independent internal verification principle  ANATOMY OF A FRAUD Bobbi Jean Donnelly, the office manager for Mod Fashions Corporation’s design center, was responsible for preparing the design center budget and reviewing expense reports submitted by design center employees. Her desire to upgrade her wardrobe got the better of her, and she enacted a fraud that involved filing expense-reimbursement requests for her own personal clothing purchases. She was able to conceal the fraud because she was responsible for reviewing all expense reports, including her own. In addition, she sometimes was given ultimate responsibility for signing off on the expense reports when her boss was ―too busy.‖ Also, because she controlled the budget, when she submitted her expenses, she coded them to budget items that she knew were running under budget, so that they would not catch anyone’s attention. Total take: $275,000 The Missing Control Independent internal verification. Bobbi Jean’s boss should have verified her expense reports. When asked what he thought her expenses were, the boss said about $10,000. At $115,000 per year, her actual expenses were more than ten times what would have been expected. However, because he was ―too busy‖ to verify her expense reports or to review the budget, he never noticed.  Cont’d HUMAN RESOURCE CONTROLS  Bond employees who handle cash.  Rotate employees’ duties and require vacations.  Conduct background checks. ANATOMY OF A FRAUD Ellen Lowry was the desk manager and Josephine Rodriquez was the head of housekeeping at the Excelsior Inn, a luxury hotel. The two best friends were so dedicated to their jobs that they never took vacations, and they frequently filled in for other employees. In fact, Ms. Rodriquez, whose job as head of housekeeping did not include cleaning rooms, often cleaned rooms herself, ―just to help the staff keep up.‖ Ellen, the desk manager, provided significant discounts to guests who paid with cash. She kept the cash and did not register the guest in the hotel’s computerized system. Instead, she took the room out of circulation ―due to routine maintenance.‖ Because the room did not show up as being used, it did not receive a normal housekeeping assignment. Instead, Josephine, the head of housekeeping, cleaned the rooms during the guests’ stay. Total take: $95,000 The Missing Control Human resource controls. Ellen, the desk manager, had been fired by a previous employer. If the Excelsior Inn had conducted a background check, it would not have hired her. The fraud was detected when Ellen missed work due to illness. A system of mandatory vacations and rotating days off would have increased the chances of detecting the fraud before it became so large.  Cont’d Question #2 The principles of internal control do not include: a. establishment of responsibility. b. documentation procedures. c. management responsibility. d. independent internal verification. Limitations of Internal Control  Costs should not exceed benefit.  Human element.  Size of the business. HELPFUL HINT Controls may vary with the risk level of the activity. For example, management may consider cash to be high risk and maintaining inventories in the stockroom as lower risk. Thus, management would have stricter controls for cash.  > DO IT! Identify which control activity is violated in each of the following situations. SOLUTION 1. The person with primary responsibility for reconciling the bank account and making all Segregation bank deposits is also the company’s of duties accountant. 2. Wellstone Company’s treasurer received an Human resource award for distinguished service because he had controls not taken a vacation in 30 years. 3. In order to save money on order slips and to reduce time spent keeping track of order slips, Documentation procedures a local bar/restaurant does not buy prenumbered order slips. 4.3. Cash Controls  Cash is the one asset that is readily convertible into any other type of asset. It also is easily concealed and transported, and is highly desired.  Because of these characteristics, cash is the asset most susceptible to fraudulent activities.  In addition, because of the large volume of cash transactions, numerous errors may occur in executing and recording them.  To safeguard cash and to ensure the accuracy of the accounting records for cash, effective internal control over cash is critical. Cash Receipt Controls Illustration 7-4 Application of Internal Control Principles to Cash Receipts  Cont’d Illustration 7-4 Application of Internal Control Principles to Cash Receipts Cash Receipt Controls OVER-THE- COUNTER RECEIPTS Important internal control principle— segregation of record-keeping from physical custody. Illustration 7-5 Control of Over-the Counter Receipts  Cont’d MAIL RECEIPTS  Mail receipts should be opened by two people, a list prepared, and each check endorsed “For Deposit Only.”  Each mail clerk signs the list to establish responsibility for the data.  Original copy of the list, along with the checks, is sent to the cashier’s department.  Copy of the list is sent to the accounting department for recording. Clerks also keep a copy.  Cont’d Question #3 Permitting only designated personnel such as cashiers to handle cash receipts is an application of the principle of: a. segregation of duties. b. establishment of responsibility. c. independent internal verification. d. human resource controls. Cash Disbursement Controls Generally, internal control over cash disbursements is more effective when companies pay by check or electronic funds transfer (EFT) rather than by cash. Applications:  Voucher System Controls  Petty Cash Fund Cash Disbursement Controls Illustration 7-6 Application of Internal Control Principles to Cash Disbursements Cash Disbursement Controls Illustration 7-6 Application of Internal Control Principles to Cash Disbursements  Cont’d Question #4 The use of prenumbered checks in disbursing cash is an application of the principle of: a. establishment of responsibility. b. segregation of duties. c. physical controls. d. documentation procedures.  Cont’d VOUCHER SYSTEM CONTROLS  A network of approvals by authorized individuals, acting independently, to ensure all disbursements by check are proper.  A voucher is an authorization form prepared for each expenditure in a voucher system. Petty Cash Fund Controls Petty Cash Fund - Used to pay small amounts. Involves: 1. establishing the fund, 2. making payments from the fund, and 3. replenishing the fund. Establishing the Petty Cash Fund Illustration: If Zhu Ltd. decides to establish a NT$3,000 fund on March 1, the journal entry is: Mar. 1 Petty Cash 3,000 Cash 3,000 Making Payments from Petty Cash  Management usually limits the size of expenditures.  Does not permit use of the fund for certain types of transactions.  Payments are documented on a prenumbered receipt.  Signatures of both the custodian and the individual receiving payment are required on the receipt.  Supporting documents should be attached to the receipt.  Custodian keeps the receipts in the petty cash box until the fund is replenished.  Sum of the receipts and money in the fund should equal the established total at all times. Replenishing the Petty Cash Fund Illustration: Assume that on March 15 Zhu’s petty cash custodian requests a check for NT$2,610. The fund contains NT$390 cash and petty cash receipts for postage NT$1,320, freight-out NT$1,140, and miscellaneous expenses NT$150. The general journal entry to record the check is: Mar. 15 Postage Expense 1,320 Freight-Out 1,140 Miscellaneous Expense 150 Cash 2,610 Replenishing the Petty Cash Fund Illustration: Occasionally, the company may need to recognize a cash shortage or overage. Assume that Zhu’s petty cash custodian has only NT$360 in cash in the fund plus the receipts as listed. The request for reimbursement would, therefore, be for NT$2,640, and Zhu would make the following entry: Mar. 15 Postage Expense 1,320 Freight-Out 1,140 Miscellaneous Expense 150 Cash Over and Short 30 Cash 2,640  > DO IT! Bateer Company established a R$50 petty cash fund on July 1. On July 30, the fund had R$12 cash remaining and petty cash receipts for postage R$14, office supplies R$10, and delivery expense R$15. Prepare journal entries to establish the fund on July 1 and to replenish the fund on July 30. July 1 Petty Cash 50 Cash 50 July 30 Postage Expense 14 Supplies 10 Delivery Expense 15 Cash Over and Short 1 Cash (R$50 – R$12) 38  4.4. Control Features: Use of a Bank Contributes to good internal control over cash.  Minimizes the amount of currency on hand.  Creates a double record of bank transactions.  Bank reconciliation. Making Bank Deposits Authorized employee should Illustration 7-8 Deposit slip make deposit. Bank Code Numbers Front Side Reverse Side Writing Checks Written order signed by depositor directing bank to pay a specified sum of money to a designated recipient. Illustration 7-9: Check With Remittance Advice Maker Payee Payer Bank Statements Illustration 7-10 Bank Statement DEBIT MEMORANDUM  Bank service charge.  NSF (not sufficient funds). CREDIT MEMORANDUM  Collect notes receivable.  Interest earned. Reconciling the Bank Account Reconcile balance per books and balance per bank to their adjusted (corrected) cash balances. Reconciling Items: 1. Deposits in transit. 2. Outstanding checks. Time Lags 3. Bank memoranda. 4. Errors.  Cont’d RECONCILIATION PROCEDURES Illustration 7-11 Bank Reconciliation Adjustments + Deposit in Transit + Notes collected by bank - Outstanding Checks - NSF (bounced) checks +/- Bank Errors - Check printing or other service charges +/- Book Errors CORRECT BALANCE CORRECT BALANCE Bank Reconciliation Illustrated The bank statement for Laird Company, in Illustration 7-10, shows a balance per bank of £15,907.45 on April 30, 2017. On this date the balance of cash per books is £11,589.45. Using the four reconciliation steps, Laird determines the following reconciling items. Step 1. Deposits In Transit: April 30 deposit (received by bank on May 1). £2,201.40 Step 2. Outstanding Checks: No. 453, £3,000.00; no. 457, £1,401.30; no. 460, £1,502.70. 5,904.00 Step 3. Errors: Laird wrote check no. 443 for £1,226.00 and the bank correctly paid that amount. However, Laird recorded the check as £1,262.00. 36.00 Step 4. Bank Memoranda: a. Credit—Collection of note receivable for £1,000 plus interest earned £50, less bank collection fee £15.00 1,035.00 b. Debit—NSF check from J. R. Baron for £425.60 425.60 c. Debit—Charge for printing company checks £30.00 30.00  Cont’d Illustration: Prepare A Bank Reconciliation at April 30. Cash balance per bank statement ₤15,907.45 Deposit in transit 2,201.40 Outstanding checks (5,904.00) Adjusted cash balance per bank ₤12,204.85 Cash balance per books ₤11,589.45 Collection of notes receivable 1,035.00 Error in check No. 443 36.00 NSF check (425.60) Bank service charge (30.00) Adjusted cash balance per books ₤12,204.85 Entries from Bank Reconciliation Collection of Note Receivable: Assuming interest of ₤50 has not been accrued and collection fee is charged to Miscellaneous Expense, the entry is: Apr. 30 Cash 1,035.00 Miscellaneous Expense 15.00 Notes Receivable 1,000.00 Interest Revenue 50.00  Cont’d Book Error: The cash disbursements journal shows that check no. 443 was a payment on account to Andrea Company, a supplier. The correcting entry is: Apr. 30 Cash 36.00 Accounts Payable 36.00 NSF Check: As indicated earlier, an NSF check becomes an account receivable to the depositor. The entry is: Apr. 30 Accounts Receivable 425.60 Cash 425.60  Cont’d Bank Service Charges: Depositors debit check printing charges (DM) and other bank service charges (SC) to Miscellaneous Expense. The entry is: Apr. 30 Miscellaneous Expense 30.00 Cash 30.00 Illustration 7-13 Adjusted Balance in Cash Account  Cont’d Question #5 The reconciling item in a bank reconciliation that will result in an adjusting entry by the depositor is: a. Outstanding Checks. b. Deposit in Transit. c. A Bank Error. d. Bank Service Charges. Electronic Funds Transfer (EFT) System EFTs  Are disbursement systems that use wire, telephone, or computers to transfer cash from one location to another.  Use is quite common.  Normally result in better internal control since no cash or checks are handled by company employees.  > DO IT! Sally Kist, owner of Linen Kist Fabrics, asks you to explain how she should treat the following reconciling items when reconciling the company’s bank account: (1) a debit memorandum for an NSF check, (2) a credit memorandum for a note collected by the bank, (3) outstanding checks, and (4) a deposit in transit.. Solution Sally should treat the reconciling items as follows. (1) NSF check: Deduct from balance per books. (2) Collection of note: Add to balance per books. (3) Outstanding checks: Deduct from balance per bank. (4) Deposit in transit: Add to balance per bank.  4.5. Reporting Cash Reporting Cash  Cash consists of coins, currency, checks, money orders, and money on hand or on deposit.  Statement of financial position reports the amount of cash available at a given point in time. ► Listed last in the current assets section. ► Includes cash on hand, cash in banks, and petty cash.  Statement of cash flows shows the sources and uses of cash during a period of time.  Cont’d Cash Equivalents Cash equivalents are short-term, highly liquid investments that are both: 1. Readily convertible to known amounts of cash, and 2. So near their maturity that their market value is relatively insensitive to changes in interest rates. Restricted Cash Cash that is not available for general use but rather is restricted for a special purpose.  Cont’d Illustration 7-14 Statement of Financial Position Presentation of Cash  Cont’d Question #6 Which of the following statements correctly describes the reporting of cash? a. Cash cannot be combined with cash equivalents. b. Restricted cash funds may be combined with cash. c. Cash is listed last in the current assets section. d. Restricted cash funds cannot be reported as a current asset.  > DO IT! Indicate whether each of the following statements is True or False. 1. Cash and cash equivalents are comprised of coins, currency (paper money), money orders, and NSF checks. 2. Restricted cash is classified as either a current asset or noncurrent asset, depending on the circumstances. 3. A company may have a negative balance in its bank account. In this case, it should offset this negative balance against cash and cash equivalents on the SoFP. 4. Because cash and cash equivalents often includes short-term investments, accounts receivable should be reported as the last item on the SoFP. The End of Chapter 4 Thank You!!!